What Is Amortization?

Amortization is the act of paying off debt through regular payments over time.  A predetermined amount of every payment is reserved for interest and the rest of the payment is set towards reducing the principal balance.  Therefore, a car loan and a mortgage are both considered to have loan amortization, whereas credit card debt has no set payoff date and would not be considered an amortized loan.  The ratio of principal to interest is decided by using an amortization schedule.

What is an amortization schedule?   

An amortization schedule is also known as an amortization table, which tells you the amount of principle and interest you are contributing to with each payment during the life of your loan.  The easiest way to get an amortization schedule is to use an amortization calculator. When you use an amortization calculator, you can customize the amount of the mortgage, loan length, and interest rate.  You will then be given your amortization schedule, which will display for you how much interest and principal makes up your monthly payment each month.

How does amortization work?

Each month, interest is calculated based on the principal balance of the loan.  For the first few years of the loan, a lot of interest will be paid until the loan balance is appropriately reduced.  Therefore, monthly payments are made towards reducing the interest first and then the principal balance.

For example, let’s look at a mortgage loan for $200,000 at 4.5% for 30 years.  The monthly principal and interest payment is $633.  For the first month, you owe interest on $200,000.  Therefore, you would pay $165 towards the principal payment and $469 would go towards the interest.  Each month, the principal amount will reduce, and therefore, your interest will reduce.  It won’t be until later on in your loan that your payments will actually start contributing to the principal and not primarily the interest. A good way to keep track of how much principle versus interest you are paying, is to keep an amortization table on hand for your review throughout the life of the loan.

Gretchen Wegrich

Gretchen Wegrich is an editor at Lender411. She specializes in mortgage basics, personal finance and green living. She graduated with a bachelor's degree in writing from University of California, San Diego and previously worked at the Santa Cruz Sentinel. Contact her at gretchen@lender411com.